An Empirical Analysis of the Monetary Policy Reaction Function in India

This paper empirically analyzes India’s monetary policy reaction function by applying the Taylor (1993) rule and its open-economy version which employs dynamic OLS. The analysis uses monthly data from the period of April 1998 to December 2007. When the simple Taylor rule was estimated for India, the output gap coefficient was statistically significant, and its sign condition was found to be consistent with theoretical rationale; however, the same was not true of the inflation coefficient. When the Taylor rule with exchange rate was estimated, the coefficients of output gap and exchange rate had statistical significance with the expected signs, whereas the results of inflation remained the same as before. Therefore, the inflation rate has not played a role in the conduct of India’s monetary policy, and it is inappropriate for India to adopt an inflation-target type policy framework.

Restructuring the state budget system for disinflation and exchange rate unification in Myanmar

The installment of a new government has augmented the prospect for implementing disinflation and exchange rate unification in Myanmar. A close look at the state budget shows that the reform of the budget system for state economic enterprises (SEEs) is essential. Reforms need to hold the replacement of controlled prices including the official exchange rate with market prices in SEE operations, and the separation of the SEEs from the state budget. But separating the SEEs from the state budget will necessitate careful planning to cope with SEE bankruptcies which would imposes another fiscal burden on the government. Therefore, economic viability must be a criterion for the continuation of their operations.

Forecasting the UK/US exchange rate with divisia monetary models and neural networks

This paper compares the UK/US exchange rate forecasting performance of linear and nonlinear models based on monetary fundamentals, to a random walk (RW) model. Structural breaks are identified and taken into account. The exchange rate forecasting framework is also used for assessing the relative merits of the official Simple Sum and the weighted Divisia measures of money. Overall, there are four main findings. First, the majority of the models with fundamentals are able to beat the RW model in forecasting the UK/US exchange rate. Second, the most accurate forecasts of the UK/US exchange rate are obtained with a nonlinear model. Third, taking into account structural breaks reveals that the Divisia aggregate performs better than its Simple Sum counterpart. Finally, Divisia-based models provide more accurate forecasts than Simple Sum-based models provided they are constructed within a nonlinear framework.

Exchange rate overvaluation under hyperinflation: The case of Peru

This dissertation examines the behavior of the exchange rate under two different scenarios. The first one is characterized by, relatively, low inflation or a situation where prices adjust sluggishly. The second is a high inflation economy where prices respond very rapidly even to unanticipated shocks. In the first one, following a monetary expansion, the exchange rate overshoots, i.e. the nominal exchange rate depreciates at a faster pace than the price level. Under high levels of inflation, prices change faster than the exchange rate so the exchange rate undershoots its long run equilibrium value.^ The standard work in this area, Dornbusch (1976), explains the overshooting process in the context of perfect capital mobility and sluggish adjustment in the goods market. A monetary expansion will make the exchange rate increase beyond its long run equilibrium value. This dissertation expands on Dornbusch's model and provides an analysis of the exchange rate under conditions of currency substitution and price flexibility, characteristics of the Peruvian economy during the hyper inflation process that took place at the end of the 1980's. The results of the modified Dornbusch model reveal that, given a monetary expansion, the change in the price level will be larger than the change in the exchange rate if prices react more than proportionally to the monetary shock.^ We will expect this over-reaction in circumstances of high inflation when the velocity of money is increasing very rapidly. Increasing velocity of money, gives rise to a higher relative price variability which in turn contributes to the appearance of new financial (and also non-financial) instruments that report a higher return than the exchange rate, causing people to switch their demand for foreign exchange to this new assets. In the context of currency substitution, economic agents hoard and use foreign exchange as a store of value. The big decline in output originated by hyper inflation induces people to sell this hoarded money to finance current expenses, increasing the supply of foreign exchange in the market. Both, the decrease in demand and the increase in supply reduce the price of foreign exchange i.e. the real exchange rate. The findings mentioned above are tested using Peruvian data for the period January 1985-July 1990, the results of the econometric estimation confirm our findings in the theoretical model. ^

Measuring persistence in nominal exchange rate: Implications for Angola’s entrepreneurship and business development

The purpose of this paper is to measure the degree of persistence in the Kwanza to US Dollar exchange rate. First, our results indicate that nominal exchange rates both in levels and in first differences are I(0), thus implying that the relative purchasing power parity hypothesis for Angola is not rejected. Secondly, we find a significant degree of persistence in both the formal and informal nominal exchange rates. Thirdly, the degree of persistence in the official market is significantly lower than in the formal market, while In first differences, persistence in the official exchange rate is substantially higher than in the informal exchange rate. Lastly, we could not find strong evidence that persistence has changed in levels throughout the sample period. By contrast, there is significant evidence that persistence in first differences has consistently increased after September 2003. These results have important policy implications as the National Bank of Angola is preparing to change its monetary and exchange-rate policy focus to a more inflation-targeting regime and to a more a flexible (or low-managed) exchange-rate regime.

Real exchange rate and elasticity of labour supply in a balance-of-payments-constrained macrodynamics

A macrodynamic model is proposed in which the real exchange rate and the elasticity of labour supply interact defining different trajectories of growth and income distribution in a developing economy. Growth depends on imports of capital goods which are paid with exports (there are no capital flows) and hence is constrained by equilibrium in current account. The role of the elasticity of labour supply is to prevent the real exchange rate from appreciating as the economy grows, thereby sustaining international competitiveness. The model allows for endogenous technological change and considers the impact of migration from the subsistence to the modern sector on the cumulative (Kaldor-Verdoorn) process of learning.

The impact of sizeof the firm and exchange rate in the export propensity of domestic and foreign owned firms in a developing country: A study of the Brazilian exporters

A Work Project, presented as part of the requirements for the Award of a Masters Degree in Management from the NOVA – School of Business and Economics

Exchange rate pressure in Angola

The objective of this work is to develop an operational tool to analyze exchange rate pressure in the context of Angola. The Angolan economy exhibits a number of relevant characteristics: a closed financial account, a partially controlled current account, a highly dollarized economy and exports (oil) price determined in World markets. These features have a direct effect on the demand of foreign currency and motivate their inclusion in the specification of a model for Angola. The model provides the rational for a measure of an exchange market rate pressure (EMP) index that contains exports changes, imports changes, the foreign interest rate and inflation and the change in foreign reserves corrected for a measure dollarization. The empirical performance new measure is comparable (slightly better) to the performance of the EMP indexes obtained in Eichengreen Rose and Wyplosz (1994) and Klassen and Jager (2011).

Current Account imbalances, thriftiness and the real exchange rate in a growing economy

This paper analyses the theoretical relevance of the dynamical aspects of growth on the discussion about the observed positive correlation between per capita real income and real exchange rates. With this purpose, we develop a simple exogenous growth model where the internal, external and intertemporal equilibrium conditions of a typical macroeconomic model are imposed; this last one through the inclusion of a balanced growth path for the foreign assets accumulation. The main result under this consideration is that the relationship defended by the Balassa-Samuelson hypothesis is no more so straightforward. In our particular approach, the mentioned bilateral relationship depends on a parameter measuring thriftiness in the economy. Therefore, the probability of ending up with a positive relationship between growth and real exchange rates -as the classical economic theory predicts- will be higher when the economy is able to maintain a minimum saving ratio. Moreover, given that our model considers a simple Keynesian consumption function, some explosive paths can also be possible.

Local Currency Pricing, Foreign Monetary Shocks and Exchange Rate Policy

The implications of local currency pricing (LCP) for monetary regime choice are analysed for a country facing foreign monetary shocks. In this analysis expenditure switching is potentially welfare reducing. This contrasts with the existing LCP literature, which focuses on productivity shocks and thus analyses a world where expenditure switching is welfare enhancing. This paper shows that, when home and foreign producers follow LCP, expenditure switching is absent and a floating rate is preferred by the home country. But when only home producers follow LCP, expenditure switching is present and a fixed rate can be welfare enhancing for the home country.

Inflation Uncertainty, Exchange Rate Depreciation and Volatility: Evidence from Ghana, Mozambique and Tanzania

While flexible exchange rates facilitate stabilisation, exchange rate fluctuations can cause real volatility. This gives policy importance to the causal relationship between exchange rate depreciation and its volatility. An exchange rate may be expected to become more volatile when the underlying currency loses value. We conjecture that a reverse causation, which further weakens the currency, may be mitigated by price stability. Data from Ghana, Mozambique and Tanzania support this: depreciation makes exchange rate more volatile for all but volatility does not causes depreciation in Tanzania which has enjoyed a more stable inflation despite all countries adopting similar macro-policies since early 1990s.

Multiple Objectives in Monetary Policy: A de Facto Analysis for ‘Advanced’ Countries

A statistical methodology is developed by which realised outcomes can be used to identify, for calendar years between 1974 and 2012, when policy makers in ‘advanced’ economies have successfully pursued single objectives of different kinds, or multiple objectives. A simple criterion is then used to distinguish between multiple objectives pure and simple and multiple objectives subject to a price stability constraint. The overall and individual country results which this methodology produces seem broadly plausible. Unconditional and conditional analyses of the inflation and growth associated with different types of objectives reveal that multiple objectives subject to a price stability constraint are associated with roughly as good economic performance as the single objective of inflation. A proposal is then made as to how the remit of an inflation-targeting central bank could be adjusted to allow it to pursue other objectives in extremis without losing the credibility effects associated with inflation targeting.

Monetary policy strategies, financial institutions and financial markets in the Middle East and North Africa: an overview

Three polar types of monetary architecture are identified together with the institutional and market infrastructure required for each type and the kinds of monetary policy feasible in each case: a ‘basic’ architecture where there is little or no financial system as such but an elementary central bank which is able to fix the exchange rate, as a substitute for a proper monetary policy; a ‘modern’ monetary architecture with developed banks, financial markets and central bank where policy choices include types of inflation targeting; and an ‘intermediate’ monetary architecture where less market-based monetary policies involving less discretion are feasible. A range of data is used to locate the various MENA countries with respect to these polar types. Five countries (Iran, Libya, Sudan, Syria and Yemen) are identified as those with the least developed monetary architecture, while Bahrain and Jordan are identified as the group at the other end of the spectrum, reaching beyond the intermediate polar type in some dimensions but not others. The countries in between vary on different dimensions but all lie between basic and intermediate architectures. The key general findings are that the MENA countries are both less differentiated and less ‘developed’ than might have been expected. The paper ends by calling for research on the costs and benefits of different types of monetary architecture.

Structural changes in the US economy: is there a role for monetary policy?

This paper investigates the contribution of monetary policy to the changes in outputgrowth and inflation dynamics in the US. We identify a policy shock and a policy rule ina time-varying coefficients VAR using robust sign restrictions. The transmission of policyshocks has been relatively stable. The variance of the policy shock has decreased over time,but policy shocks account for a small fraction of the level and of the variations in inflationand output growth volatility and persistence. We find little evidence of a significant increasein the long run response of the interest rate to inflation. A more aggressive inflation policyin the 1970s would have produced large output growth costs.

Which inflation to target? A small open economy with sticky wages indexed to past inflation

In a closed economy context there is common agreement on price inflation stabilization being one of the objects of monetary policy. Moving to an open economy context gives rise to the coexistence of two measures of inflation: domestic inflation (DI) and consumer price inflation (CPI). Which one of the two measures should be the target variable? This is the question addressed in this paper. In particular, I use a small open economy model to show that once sticky wages indexed to past CPI inflation are introduced, a complete inward looking monetary policy is no more optimal. I first, derive a loss function from a secondorder approximation of the utility function and then, I compute the fully optimalmonetary policy under commitment. Then, I use the optimal monetary policy as a benchmark to compare the performance of different monetary policy rules. The main result is that once a positive degree of indexation is introduced in the model the rule performing better (among the Taylor type rules considered) is the one targeting wage inflation and CPI inflation. Moreover this rule delivers results very close to the one obtained under the fully optimal monetary policy with commitment.